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Persistent gaps and default traps

  • Catão, Luis A.V.
  • Fostel, Ana
  • Kapur, Sandeep

We show how vicious circles in countries' credit histories arise in a model where output persistence is coupled with asymmetric information about output shocks. In such an environment, default signals the borrower's vulnerability to adverse shocks and creates a pessimistic growth outlook. This translates into higher interest spreads and debt servicing costs relative to income, raising the cost of future repayments, thereby creating "default traps". We build a long and broad cross-country dataset to show the existence of a history-dependent "default premium" and of significant effects of output persistence on sovereign creditworthiness, consistent with the model's predictions.

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Article provided by Elsevier in its journal Journal of Development Economics.

Volume (Year): 89 (2009)
Issue (Month): 2 (July)
Pages: 271-284

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Handle: RePEc:eee:deveco:v:89:y:2009:i:2:p:271-284
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